K2 Advisors: It’s the End of the Fed’s World as We Know ItFeb 8, 2019

Market volatility returned with a vengeance towards the end of 2018, invoking memories of the Great Recession. K2 Advisors’ Robert Christian and Brooks Ritchey believe the most recent turmoil has been a function of some asset-price distortions stemming from central bank actions. They explain what it all means for investors—and for hedge-fund vehicles in particular.

K2 Advisors: It’s the End of the Fed’s World as We Know It

Painful memories of the “Great Recession” howled back to the surface in the fourth quarter of 2018. Volatility returned, and asset classes across industries, geographies and capital structures were significantly challenged—often indiscriminately.

In our view, this most recent tempest is a function of markets beginning to connect the dots between the 10+ year bull market in risk assets and its association with cheap government money. That is, the spectacular rebound we’ve enjoyed since 2008 was in some parts synthetically driven.

While the US Federal Reserve’s (Fed’s) massive quantitative easing (QE) programme was originally deployed to stabilise financial markets, it created asset price distortions along the way. We believe these are beginning to correct.

The QE response to the 2008 crisis was swift and surprisingly effective, but in many ways, it treated only symptoms and not the cause. Essentially more leverage was added to the system, not removed. Debt was moved from one pocket to the other—from the private sector to the public. In addition, instead of it being a short-term intervention, QE persisted for more than a decade.

The result? Bond yields were pushed down and equities buoyed, while the costs of capital were kept artificially suppressed. This steered many investors towards riskier assets, encouraged leverage and, in some instances, rewarded complacency.

Looking ahead, we expect the reversal of QE to have significant impacts on bond and equity markets. Persistently low yields and the Fed’s “buyer of last resort” role will not be a permanent arrangement. The dynamic cannot be sustained.

Ultimately many of the financial sins of the “Great Recession” (unwarranted debt, excessive leverage and spending, etc.) have yet to be fully atoned. At some point, the world’s margins will have to be called.

Just this past fall, we saw bond and equity markets in the United States decline concurrently as interest rates rose. That may seem anomalous, but in our view, because bonds and equities were equally propped up by Fed intervention, they have been equally vulnerable to the opposite effect as Fed policy unwinds. These are the types of valuation corrections we expect to see as the artificial effects of prolonged monetary accommodation are dismantled. Investors who are not prepared in 2019 may be exposed to unintended risks.

So what does this all mean for hedge funds? From a very high level, we would say the environment looking forward is promising. While no one wins with panicked, indiscriminate and forced selling, modest volatility is good in that it provides intelligently hedged strategies an opportunity to earn fundamental alpha on both sides (long and short) of their trades.

Discretionary Macro

There are many potentially attractive trade opportunities for discretionary managers. These stem from broad macro risks, including the aforementioned central bank policy divergence and geopolitical risks associated with leadership changes in major economies. The importance of those factors was highlighted by the recent market selloff, and we believe they will continue to drive market volatility. Recent increases in volatility favour managers with return profiles positioned to take advantage of increased volatility and expertise in diversifying asset classes, including commodities, currencies and fixed income.

K2 Advisors: It’s the End of the Fed’s World as We Know It

Relative Value Fixed Income – Sovereign

Diverging macroeconomic data, and varied policy responses coming from central bankers in both developed and emerging markets are likely to persist in the intermediate term. Resulting price action in global fixed income markets is expected to remain volatile and potentially create attractive trading opportunities, favouring relative value opportunities rather than outright directional bets.

K2 Advisors: It’s the End of the Fed’s World as We Know It

Long/Short Credit

With interest rates generally higher over the course of 2018, we expect that portfolio duration has likely driven losses for some fixed income investors. Long/short credit managers are well positioned for this environment, given their shorter duration portfolios, and should be able to generate alpha from rising sector and rating bucket dispersion. Managers are seeing many buying opportunities in select higher quality credits given recent spread widening around year-end.

K2 Advisors: It’s the End of the Fed’s World as We Know It

The comments, opinions and analyses are the personal views expressed by the investment managers and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.

Hedge funds are complex investments and may not be appropriate for all investors. Investment in these types of hedge-fund strategies is subject to those market risks common to entities investing in all types of securities, including market volatility. There can be no assurance that the investment strategies employed by hedge fund and liquid alternative managers will be successful. It is always possible that any trade could generate a loss if the manager’s expectations do not come to pass. Hedge strategy outlooks are determined relative to other hedge strategies and do not represent an opinion regarding absolute expected future performance or risk of any strategy or sub-strategy. Conviction sentiment is determined by the K2 Advisors’ Research group based on a variety of factors deemed relevant to the analyst(s) covering the strategy or sub-strategy and may change from time to time in the analyst’s sole discretion.

These materials reflect the analysis and opinions of K2 Advisors, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments.